East European economies

To the barricades
Jan 22nd 2009 | VILNIUS
From The Economist print edition


Economic pain brings political ructions

IN INTENSIVE care but angry: that describes Latvia’s economy after its dramatic rescue by the IMF and other foreign lenders. Now the question is whether the tough conditions imposed by the bail-out are politically tolerable. A riot in Riga, in which more than 40 people (including 14 police officers) were hurt and 106 arrested, suggests there is a bumpy ride ahead.

Latvia, a country of 2.4m that may soon be the sixth-biggest debtor to the IMF, is not alone. Lithuania has pushed through similarly tough wage and spending cuts and tax rises. A protest on January 16th turned violent, with protesters pelting the police with snowballs and stones. After a decade in which breakneck growth made up for political weaknesses, pessimists fear that the post-cold war settlement across eastern Europe may now be at risk.

That settlement rested on three notions. One was that Western-style politics was both trustworthy and efficient, in contrast to the failures of communism. The second was that welfare capitalism and integration into Western markets would produce prosperity. And the third was that joining the European Union would provide a guarantee of economic and political security. All three now look wobbly.

In 2006 Latvia’s economy was still growing by an astonishing 12% a year. One reason was that locally owned banks—comprising some 40% of the financial system—took deposits from foreigners (chiefly Russians) and invested in an increasingly frothy property market. The government not only failed to supervise them properly. It also inflated the bubble by running a loose fiscal policy.

The biggest local bank, Parex, collapsed and has been largely nationalised. Outsiders going through the books are finding much to be glum about. At worst, the Latvian taxpayer faces a bill of up to $3 billion. Even at best the country faces several painful years as it tries to regain competitiveness. Such pain may have been tolerable after 1991 when problems could be blamed on communist times. Nobody knows where public anger will focus now.

The IMF and others believe that the best solution would have been immediate devaluation of the national currency, the lat, accompanied by its replacement by the euro. That would have hurt the many households and businesses that have borrowed in foreign currency. But calculations published by the IMF suggest that the recovery thereafter would have been quicker and steeper.



Yet euroisation has proved impossible. The European Central Bank and the European Commission were unwilling to change their rules. And the overwhelming consensus in Latvia favours keeping the lat’s currency peg. Neither the protesters in Riga nor opposition politicians want a devaluation. Their most controversial demand is for a progressive income tax (Latvia, like its neighbours, has a flat tax).

Ainars Slesers, the transport minister, is suggesting legal action to protect creditors of the Nordic-owned banks that make up most of the rest of the financial system. He blames their irresponsible lending for stoking the boom. Yet it is only foreign banks’ willingness to stump up for their losses that is keeping Latvia afloat. Shares in Nordic banks such as Swedbank and SEB have plunged because of worries about their exposure to bad Baltic loans.

Latvia’s prime minister, Ivars Godmanis, is widely seen as a competent heavyweight. But he depends on powerful political barons such as Mr Slesers to support his governing coalition. The president, Valdis Zatlers, wants a cabinet shuffle to dump discredited figures. Failing that, an early election in the summer looks likely. Yet Latvia’s opposition parties are a motley lot; and no policy mix can now avoid economic pain.

Most other east European EU members are in a better way, at least for now. Estonia was more prudent during the boom, building up net public assets equivalent to 7% of GDP. It can now run an expansionary fiscal policy that offsets the recession, rather than a tight one that aggravates it, as in Latvia and Lithuania. Estonia’s banks are almost all foreign-owned. Even Lithuania’s dodgiest local bank is nothing like as troubled as Parex in Latvia.

Not that the foreign-owned banks are in great shape. Across the region cash-strapped banks are cutting business loans, worsening the downturn. No international or national institution has the authority to deal with banks that take deposits in one country and lend in another, often with managers in a third country and shareholders in a fourth. Neither the IMF nor the ECB is set up to deal with these beasts.

The biggest concern is how far the economic weakness will spread. Poland, the biggest regional economy, has looked fairly safe. The central bank has even cut interest rates sharply, after raising them in 2008. But industrial production is plummeting, with inevitable effects on tax revenues. By the summer the government will have to choose between maintaining a tough fiscal stance (a condition for joining the euro) and easing the pain of recession. At least Poland has a choice. Hungary, the most indebted country in the region, has little option but to tighten its belt further.

Governments normally respond to recession by loosening fiscal policies to preserve jobs and output. But most in eastern Europe cannot do this. Their debts make it hard to borrow more. Currency pegs in the Baltics and Bulgaria that once seemed to offer stability and a smooth path to the euro now put the burden of adjustment wholly on wages and output. The voters, many of whom suffered gas cut-offs in Russia’s gas spat with Ukraine, won’t like it. What will they do? Nobody knows.